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Think of investments as ingredients of a stew, some with fat returns and some with lean. Now think of the investment market as a giant well-mixed vat of stew that contains all investments. Some investors dip their ladles into the stew and fill them with fat and lean in proportions equal to the proportions in the market vat. These are index investors who buy index funds that contain all investments. Index investors pay the expenses of their funds, but they can easily find index funds whose expenses are very low, equivalent to a few teaspoons of stew taken out of their ladles. Index investors tend to be buy-and-hold investors who trade only infrequently, as when they invest savings from their paychecks into index funds during their working years and withdraw them in retirement.

While index investors are satisfied with returns equal to risks, beat-the-market investors search for returns higher than risks. Some beat-the-market investors choose handfuls of investments and trade them frequently, hoping to fill their ladles with more fat returns than in the ladles of index investors. Others buy beat-the-market mutual funds, exchange traded funds, or hedge funds, hoping that their managers would find stocks with fat returns. But not all beat-the-market investors can be above average. The ladles of index investors are filled with average amounts of fat returns. If some beat-the-market investors fill their ladles with above-average fat returns, other beat-the-market investors are left with below-average fat returns in their ladles. Moreover, the expenses of beat-the-market investors are higher than those of index investors because beat-the-market investors pay higher costs of trading and the higher costs of beat-the-market managers. Beat-the-market costs are substantial. By one estimate, investors would have saved more than $100 billion each year by investing in low-cost index funds and foregoing attempts to beat-the-market by on their own or by paying money managers to do it for them.

The beat-the-market puzzle

Why don’t beat-the-market investors abandon their game and join index investors? One part of the answer is easy. While average beat-the-market investors cannot beat the market, some beat-the-market investors are above average. Professional investors, such as mutual fund and hedge fund managers, regularly beat the market. Stocks bought by beat-the-market mutual fund managers had higher returns than stocks sold by them. And hedge fund managers are famous for the billion-dollar paychecks they earn by beating the market. But investors in beat-the-market mutual funds trail investors in index funds because the costs of beat-the-market mutual funds detract from the returns passed on to investors more than managers add to them. Hedge funds are riskier than investors believe and the returns they pass on to investors are lower than investors believe.

Highly intelligent investors might be able to beat the market, but their success is far from assured because intelligent investors are not always wise. Harvard staff members are intelligent and so are Harvard undergraduate students with SAT scores in the 99th percentile as are Wharton MBA students with SAT scores at the 98th percentile. Staff and students received information about past performance and fees of index funds that track the S&P 500 Index. But the information about the funds varied by the dates when the funds were established and the dates when the funds’ prospectuses were published.

Wise investors faced with a choice among index funds following the S&P 500 Index choose the index fund with the lowest fees since these index funds are otherwise as identical as identical cereal boxes. But nine out of ten staff and college students chose index funds with higher fees and so did eight out of ten MBA students. Staff and students chased returns instead, choosing funds with the highest historical returns, apparently assuming that these offer returns higher than risks.

Insiders Deepen the Beat-the-Market Puzzle

Some investors have access to inside information, such as information about mergers being negotiated or disappointing earnings about to be revealed. Investors with inside information include corporate executives and investors with links to executives, including investment bankers and hedge fund managers. Members of Congress have inside information as well. Only one-third of American senators bought or sold stocks in any one year during the boom years of the 1990s but trading senators did very well. While corporate insiders beat the market by six percentage points each year on average, trading senators beat it by 12 percentage points. “I don’t think you need much of an imagination to realize that they’re in the know,” said Alan Ziobrowski, one of the authors of the study.

The success of insiders in the beat-the-market game only deepens its puzzle. Insiders fill their investment market ladles with above-average proportions of fat returns, while index investors fill their ladles with average proportions of fat returns. This leaves below-average proportions of fat returns in the ladles of outsiders in the beat-the-market game, even if we set aside the cost of playing the game.

A two-part solution to the beat-the-market puzzle

Why don’t outside investors quit the beat-the-market game? Why do investors search for money managers who would bring them ladles of beat-the-market returns even after managers have scooped expenses and compensation from the ladles? One part of the answer is in cognitive errors and emotions which mislead us into thinking and feeling that we or our managers can easily beat the market. The other part is in what we really want from our investments, including our desire to play the investment game and win.

Framing errors are some of the cognitive errors which mislead us into thinking that beating the market is easy. In particular, we fail to frame the investment market as a vat of investment stew where relatively high returns for one investor imply relatively low returns for another. You might object, noting that there are many investment vats rather than one. Some investment vats, such as the private equities vat, might have more fat returns in them than the vat of public equities. Private equity vats, unlike public equities vats, can be consumed only by large investors, undisturbed by hordes of small investors. Yet investors in private equities are far from assured that their managers would share the fat. Tom Perkins, a wealthy manager of a venture capital, tells about Harry, one of his investors, who asked him how he can live with the risk of his investments. “Well, Harry,” laughed Perkins, “it’s your money!”

Emotions join cognitive errors in persuading investors that beating the market is easy. Individual investors are often unrealistically optimistic, but they are regularly joined by professional investors who are flattered as sophisticated players just before they are fleeced. Lloyd Blankfein, the chief of Goldman Sachs, described investors who lost to Goldman at the mortgage securities game as sophisticated investors. But Phil Angelides, who questioned Blankfein at the Financial Crisis Inquiry Commission, said: “Well, I’m just going to be blunt with you. It sounds to me a little bit like selling a car with faulty brakes, and then buying an insurance policy on the buyer of those cars, the pension funds who have the life savings of police officers, teachers.” Jeff Macke, an investment advisor, elaborated: “Of course [Goldman Sachs traders] know more than the other guys,” he said to Paul Solman of PBS’ Newshour. And, if they’re selling it, well, you probably don’t want to be a buyer.” Macke failed to persuade Solman. “But pension funds don’t bring in the math whizzes, the quants, the people that Goldman Sachs has,” said Solman, “They’re no match for Goldman Sachs’ salespeople or traders.” Macke was ready when Solman was done. “Generally speaking, they aren’t,” said Macke. “So, what is a pension fund doing involved in these securities?” Unrealistic optimism is a likely answer. Pension fund managers believed that they had a realistic chance to win their game when, in truth, they were unrealistically optimistic.

“Not at all,” said J.H.B., “They go in for the pleasure of getting something for nothing….What they want is a thrill. That is why we…drink bootleg whisky, and kiss the girls, and take new jobs. We want thrills. It’s perfectly human, but Wall Street is a poor place to look for thrills, for the simple reason that thrills in Wall Street are very expensive.”

J.H.B. was speaking in 1930, when Prohibition was the law, and whisky was bootlegged. The world has changed greatly since then, but our wants remain the same. Woodward is not entirely wrong. We do want to make money from investing and speculating. But J.H.B. is surely right. We want pleasure from investing and speculating, and we want thrills from playing the beat-the-market game and winning it. Wall Street is still a poor place to look for thrills and Wall Street thrills remain expensive, but we are willing to pay the price.

Investments offer three kinds of benefits: utilitarian, expressive, and emotional, and we face tradeoffs as we choose among them. The utilitarian benefits of investments are in what they do for our pocketbooks. The expressive benefits of investments are in what they convey to us and to others about our values, tastes, and status. Some express their values by investing in companies that treat their employees well. Others express their status by investing in hedge funds. And the emotional benefits of investments are in how they make us feel. Bonds make us feel secure and stocks give us hope.

Profits are the utilitarian benefits of winning the beat-the-market game, and cognitive errors and emotions mislead us into thinking that winning is easy. But we are also drawn into the game by the promise of expressive and emotional benefits. Indeed, we are willing to forego the utilitarian benefits of profits for the expressive and emotional benefits of playing the beat-the-market game and hoping to win that game.

Dutch investors care about the expressive and emotional benefits of investing more than they care about its utilitarian benefits. They tend to agree with the statement “I invest because I like to analyze problems, look for new constructions, and learn” and the statement “I invest because it is a nice free-time activity” more than they agreed with the statement “I invest because I want to safeguard my retirement.” German investors who find investing enjoyable trade twice as much as other investors. And a quarter of American investors buy stocks as a hobby or because it is something they enjoy.

Mutual Funds magazine interviewed Charles Schwab, the founder of the investment company bearing his name. Schwab said: “If you get… an S&P Index return, 11% or 12% probably compounded for 10, 15, 20 years, you’ll be in the 85th percentile of performance. Why would you screw it up?”

The interviewer went on to ask Schwab why he thought people invested in actively managed funds at all. “It’s fun to play around,” answered Schwab. “People love doing that, they love to find winners… it’s human nature to try to select the right horse. It’s fun. There’s much more sport to it than just buying an index fund.”

It is often hard to distinguish facts from cognitive errors and even harder to distinguish cognitive errors from wants of expressive and emotional benefits. We should empathize with fellow investors who do not share our wants. Some of us are passionate players of the investment game, willing to pay commissions for trades, subscriptions for newsletters that promise to foresee the market, and fees for money managers that promise to beat it. I empathize with their passions even if I don’t share them. Yet I see no benefit in cognitive errors and emotions that mislead us into sacrificing utilitarian benefits for no benefits at all. No benefit comes from playing the beat-the-market game because we fail to understand that it is difficult to win. And no benefit comes from failing to make wise choices among utilitarian, expressive, and emotional benefits. We can increase the sum of our benefits if we understand our investment wants, overcome our cognitive errors and misleading emotions, weigh the tradeoffs between benefits, and choose wisely.